Investing in tech stocks can offer big rewards but not without risk

Strong performance from tech stocks has rekindled memories of the dot-com bubble and the resulting crash that struck at the turn of the millennium.

US internet stocks have again been among the strongest performing areas of the market; Netflix has risen 1507% over the past five years, while Facebook, Amazon and Alphabet are up by 477%, 355% and 226% respectively.

Then there´s Tesla, a technology orientated car manufacturer that´s seen its share price rise by 977% over the same period.

Does this all mean investors have become a little over exuberant for everything that is new and shiny? Or are these big share price rises somehow justified?

Tech shares as jam tomorrow

Tech shares are typically thought of as “jam tomorrow” investments. In the earlier years, such firms should be expected to necessitate high levels of investment in R&D.

Investors who get in early can stand to make spectacular returns, but may lose all if the technology or business model is unproven. On the other hand, investors risk overpaying if they put their money in a tech stock that has already skyrocketed on seemingly early successes.

If the technology and business model does stack up, another major problem could be competition. Barriers to entry are therefore important; what´s to stop a competitor from muscling in and taking all the spoils?

Resources for growth

Internet video streaming name Netflix is one of the best-performing stocks in the market this year, having risen by around 50%. There are some similarities with Amazon in the general way that Netflix has sought to execute its business strategy.

Runaway subscriber growth has been propelling the stock higher, but Netflix insists on aggressively reinvesting in the business with the hope of boosting profits in future years.

Amazon, meanwhile, has seen its profits significantly beat expectations this year, after having run the business at a breakeven point for virtually all its history, as it ploughed available cash into expansion.

Outsized P/E

At 230 times earnings, Netflix´s valuation in P/E terms appears rich to say the least! It is a classic jam tomorrow story in that it can only hope to justify its lofty share price if it manages to grow earnings by multiples in future years.

Even after the earnings successes of this year, Amazon´s P/E multiple also appears rather lofty, at 194 times.

Not all tech stocks command such incredible P/E multiples though. The Dow Jones US Technology index currently has a P/E multiple of around 24 times, just modestly higher than that of the broad US blue-chip S&P 500, which trades at 22 times.

Alongside Amazon, the other two biggest internet companies in the world are Facebook and Google parent Alphabet, which have P/E ratios of 41 and 33 respectively.

Netflix is one of the best-performing stocks this year.

A screaming buy?

In comparison to some of the US internet names, Apple appears to be a screaming buy at a valuation of just 18 times earnings.

Much of Apple´s growth in recent years has been propelled by the phenomenal success of its iPhone, which accounts for around two thirds of its revenue. There´s plenty of excitement surrounding the imminent launch of its iPhone 8.

Further down the line, there is the question as to whether Apple will be able to maintain its growth momentum, especially as it has become quite reliant on the iPhone. The smartphone market is highly competitive.

Apple´s sales have risen by over 100% since 2011, while its share price has advanced by 76% over the past five years.

Estimates suggest Apple´s 2017 fiscal year revenue will hit $226bn, before growing another 13% to reach $255bn by 2018. The following year, however, growth is expected to have petered out with sales forecast to come in at around the $258bn mark in fiscal 2019.

Tesla encapsulates why investors are so often drawn to technology focused companies.

No earnings?

Loss-making electric car manufacturer and sustainable energy company Tesla encapsulates why investors are so often drawn to technology focused companies.

Rapid sales growth underpinned by shiny new technology means investors are hoping that ongoing innovation and the growing popularity of its products will enable the company to eventually turn healthy profits.

In April, Tesla overtook GM to become the most valuable US car manufacturer by market cap. There is, however, much debate over whether Tesla will survive in the longer term as existing global car makers increasingly adopt electric car technology themselves.

The main consideration for investors should be to avoid overpaying for stocks such as Tesla. As it does not generate any profits, metrics such as P/E cannot be applied; the “E” in the ratio is below zero.

Tesla´s P/S ratio

However, the price to sales (P/S) ratio can be suitably applied to give us some understanding of its valuation. Tesla has a P/S ratio of around 6, which hardly makes the stock appear cheap.

At the same time, its P/S has come down considerably since 2013 when it was as high as 24; this phenomenon reflects strong sales growth. The ratio may soon fall again if Tesla sees some success through its new mass market Model 3 vehicle, which it launched only this month.

Tesla´s current P/S makes it appear about three times more expensive than the average stock within the S&P 500, where the average P/S ratio is around 2. Investors must ask themselves whether this valuation premium is justified.

Will Tesla´s future revenue growth be that much stronger than the average stock in the market?

One of Tesla´s electric cars.

Overvalued?

Those stocks with relatively high P/E ratios are under immense pressure to deliver the earnings that match investors´ elevated expectations.

Alphabet shares were hit in late July after second-quarter results were impacted by a $2.7bn fine from the EU on competition grounds. Despite overall earnings being slightly ahead of expectations, the shares dipped by around 3% in the aftermath of the results following strong year-to-date gains.

Netflix, with its astronomical P/E ratio, actually saw its share price surge by 10% after it reported second-quarter results this month, against further strong growth in subscriber numbers.

The latter has seen Netflix achieve runaway sales growth over recent years. Revenue has grown from $1.25bn in 2008 to around $10.2bn today. However, free cash flow remains negative while debt levels are elevated as it continues to reinvest large sums into generating original content for its growing subscriber base.

Cybersecurity must surely be the obvious place for investors to look next.

Where next?

Cybersecurity must surely be the obvious place for investors to look next for above average growth. The cyber threats faced by global corporations and governments appear to get worse every year.

A cyberattack has the potential to put a company´s future on the line or even compromise national security. Indeed, hacking was blamed for influencing the outcome of last year´s US presidential election.

Against this very worrying backdrop, big corporations and governments are set to increasingly allocate funds towards beefing up their cyber defences and generally improving their organisation´s cybersecurity as much as possible.

As with all apparent “no brainers” though, a significant amount of research and analysis is warranted to identify those cybersecurity providers who are best placed to benefit from this growing trend.

Potential candidates include the likes of Palo Alto Networks, Fortinet, Sophos and CyberArk.

March 2000 peak revisited

The dot-com crash at the turn of the millennium was such that it was only this month that US technology stocks as measured by the S&P 500 technology segment finally managed to rise above their March-2000 peak.

It’s a salutary lesson for investors who are seeking stocks that offer higher growth potential than average; however captivating a business model may appear, it´s extremely important to avoid overpaying.

On a roll

Some 17 years ago, a very high proportion of internet names were loss making. Today, big US internet stocks such as Alphabet, Amazon and Facebook are raking in some of the largest corporate earnings on earth.

Investors, however, still need to question the valuations of such stocks, especially as much of the inherent premiums in their share prices are dependent on further profits growth over future years.

Technology stocks in general have been on a roll this year as investors seek out growth opportunities. By the same token, the sector could easily prove to be susceptible to any broader retrenchment in investor risk appetite over the months and years ahead.

Capital Com SV Investments Limited is a Cyprus Registered Company with Company Registration Number HE 354252. It is a regulated Cyprus Investment Firm, licensed by the Cyprus Securities and Exchange Commission (CySEC), under license number 319/17.Capital Com SV Investments is authorised to provide investment services in more than 20 European countries.It is an Investment Firm following the implementation of the Markets in Financial Instruments Directive (MiFID).

The information found on this website isn’t applicable to residents of the USA or Belgium and shall not be used or distributed in any country or jurisdiction where it goes against domestic legislation and regulations.

All content on this website belongs to Capital.com, unless stated otherwise. Any of the website content that belongs to Capital.com is licensed under a Creative Commons Attribution-NonCommercial 4.0 International License. Whenever shared or adapted the content must be accompanied with appropriate credit to Capital.com with links or hypertexts leading to Capital.com and the initial page of the content's publication on Capital.com. All third-party owned content appearing on this website is subject to the rights of their respective owners and the applicable distribution rules.